Private equity in the pink

TPG Capital’s Ben Gray and Carlyle Group’s Simon Moore have given an emphatic message that private equity is back in the groove with the formal $2.7 billion takeover offer for private hospitals group
Healthscope
.

It is Australia’s biggest leveraged buyout, eclipsing the $1.22 billion takeover of radiology and nursing home company DCA Group by CVC Asia Pacific in 2006.

TPG and Carlyle are stumping up about $1.4 billion in equity, and borrowing $1.2 billion to buy a well-run business that has ambitious expansion plans.

A total of 17 banks have committed to lend on the Healthscope deal. The lending syndicate was worked out bilaterally – not like the old days, when one bank did the deal and then syndicated the loan.

The banks are charging 10 per cent interest, which is the bank five-year bill swap rate of about 5.5 per cent plus a margin of 4.5 per cent.

Private equity is back partly because of the opportunities presented by a weaker equity market, but also because of pressure from their own investors to place committed capital.

Private equity charges its investors an annual management fee of about 2 per cent on committed capital but that can only be justified if investments are being made. The risk is that, if funds are not put to work, the investors will want to revisit the fees.

Over the past few years funds have had difficulty placing committed capital because of nervousness among banks to provide leveraged lending. But the Healthscope deal shows that, while banks are still ­cautious, they are not saying no to leverage.

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The Healthscope balance sheet will be expanded so that interest eats up all of its expected earnings before interest and tax of about $200 million in 2011.

To get an idea of the pressure that TPG and Carlyle were under to invest, you only need look at the funds used in the Healthscope transaction.

One of the funds used by TPG, the TPG Asia V fund, raised about $US4.25 billion in 2007, according to Capital IQ. Another fund being used for the transaction, the TPG Partners VI fund, raised $US18.8 billion in 2008.

Carlyle is sourcing its funds for the Healthscope bid from Carlyle Asia Partners III, which raised $US2.6 billion in 2007.

A back of the envelope calculation says TPG and Carlyle, which have a small number of partners relative to the money they manage, have pulled in at least $60 million while sitting on the money earmarked for the Healthscope offer.

More private equity money is waiting in the wings. The firms that lost out in the Healthscope bid include Blackstone and Kohlberg Kravis & Roberts. Bankers reckon they are looking around for other opportunities in Australia, and not just in healthcare.

Healthcare has been a favourite of private equity for some years because of the growth inherent in a sector that serves an ageing population of wealthy and relatively healthy people who are happy to pay for new knees and hip joints. TPG and Blackstone have spent about $US10 billion on healthcare related businesses in the United States this year.

Healthscope’s private hospital division, which provides about 75 per cent of annual profits, has about a dozen hospital expansion projects in the pipeline. TPG and Carlyle are expected to ramp up investment in new facilities to capture the growth and build earnings for a return to the stockmarket in three to five years.

One of the lessons from TPG’s ownership of the Myer department store business was that private equity was eager to make substantial capital commitments. Annual capital expenditure at Myer doubled after TPG bought the business and was running at about $130 to $150 million a year.

About half the $500 million that TPG invested in Myer went into technology systems because the company was lumbered with ageing systems, including a point of sales system that was 15 years old.

When TPG took control of Myer it was returning about 2¢ in the dollar; by the time it was sold it was returning about 7¢ in the dollar.

Myer was able to make decisions about its capital investment free of the pressures of the equity market. Its aggressive cost-cutting campaign also delivered higher earnings, but that is not a recipe for sustained growth. Another lesson from the Myer experience was that private equity had to be careful when selling cyclical businesses.

If it sold a business at the top of the market it would leave a sour taste that would take a long time to forget. Healthscope will probably be easier to sell back to the market because it is not cyclical. But TPG will have work to do when it seeks to exit the business. It will have to show it is willing to leave something on the table.

The Healthscope sale process is emerging as the new model for selling a company behind closed doors.

The company’s board had two separate private equity consortiums vying for the business at the same time.

Early in the process, the company set a price that became the hurdle for doing a deal.

This was done behind closed doors and allowed information to keep flowing from the bidder to the target. The bidders were kept in the dark about what the other parties were up to.

The company worked out the contracts with each consortium as the due diligence was being undertaken. Contractual terms are well sorted before the process reaches the final bidding stage which is done using a blind auction.

Some of the terms of the contract were quite favourable to Healthscope, including the reverse break fee of $30 million, which was backed up by a letter of credit. That letter of credit was important because it meant that Healthscope was not exposed to a shelf company if TPG and Carlyle walked away. Also, the $20 million break fee payable by Healthscope would normally carry about five or six conditions but in this case there was only one.

Other terms that were favourable to the target included the lack of any out clause because of a fall in the stockmarket index.

The blind auction started last Friday, when the two competing consortiums were asked to give their best offers – but it had to have a 6 in front of it. The bidders were never told exactly what the other side was bidding.

Over the weekend, the bankers for Healthscope went back to the bidders and asked them to put their best offer.

The final price of $6.26 is at a multiple of 10 times enterprise value to earnings before interest, tax, depreciation and amortisation.

Healthscope shareholders can thank their board for getting a price up front that would not be achieved for several years.